Best way to buy a business

Typically, ownership of an incorporated business changes hands through either a stock purchase or an asset purchase. Both methods have pros and cons for buyer and seller. There is a third way that often gives the buyer the best of both approaches: an IRC Section 338(h)(10) election.

This tax vehicle allows a buyer to enjoy the tax benefits offered by an asset sale, while structuring the transaction as a stock sale. It allows the seller to dispose of the entire business, liabilities and all, and permits the buyer to receive a tax deduction for the premium they paid in the form of goodwill.

A Sec. 338(h)(10) election lets a corporation that makes a qualified stock purchase of another corporation treat the stock purchase as an asset purchase for federal tax purposes. That’s good news for buyers if they pay a premium because a corporation that purchases assets receives a tax basis in the assets equal the purchase price. If the buyer purchased a corporation’s stock instead, the seller’s tax basis of the underlying assets would carry over to the buyer, generally unchanged.

Sec. 338(h)(10) elections require that a purchaser acquire 80 percent of the vote and value of the target company’s stock.

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The election causes the target company to be deemed to “have sold its assets in a taxable transaction and then distributed the proceeds in a constructive liquidation, while still a member of the selling consolidated group or while still owned by the selling affiliate or S corporation shareholders,” according to the IRS. As a result, the target’s stock sale will be ignored, and the distribution of the proceeds from the sale will be treated as a complete liquidation.

It is important to understand that a Sec. 338(h)(10) election is not a unilateral election like other elections. Both buyer and seller must jointly make this election. Therefore, it is an issue to raise early on, so tax considerations relevant to each party can be evaluated. While in nine out of 10 situations the election makes business sense for the buyer, there exist those rare cases when it does not – where an ill-advised election could lead to trouble. That could include a buyer being forced to step down the basis of acquired assets or the seller paying excess taxes – so an election should only be made after careful evaluation.

The key for the buyer is to focus on a premium being paid over the value of the underlying assets. The seller must consider the difference between their outside basis in the stock of the selling corporation versus the basis in the assets held within the corporation. In a noncorporate parent situation, the seller also must evaluate the tax rate differential between the varying assets being sold.

Sec. 338(h)(10) elections are available only to C or S corporations, not LLCs or sole proprietorships, and only specific targets are eligible. As summarized in the Small Business Jobs Act of 2010, Sec. 338(h)(10) elections are possible if:

n The target is a member of a consolidated group, a nonconsolidated selling affiliate, or an S corporation.

n The purchaser must also acquire a minimum percentage of the target’s stock from a selling consolidated group, a selling or S-corporation shareholders by vote and value (after excluding any nonvoting, nonconvertible preferred stock) within a defined acquisition period.

Part II of this column next week will cover issues of concern to sellers of a business and some cautionary comments about IRC Section 338(h)(10) elections. •

Carl J. Giardino is a managing director in the Tax Group at CBIZ Tofias, which has offices in Providence, Boston and nationwide.

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